Extent to Which Forward Market Is an Unbiased Predictor of the Spot Market - Assignment Example

Extent to which Forward market is an unbiased predictor of the spot market Name Course Tutor Date Table of Content 1.0 Introduction....................................................................................................................3 2.0 The forward market........................................................................................................3 3.0 Types of Forward exchange contracts............................................................................4 3.1 Fixed contracts…………………………………..........................................................4 3.2 Partially optional contracts.............................................................................................5 3.3 Fully optional contracts..................................................................................................5 4.0 Forward market exchange rates (pricing)......................................................................5 5.0 The Spot Market…........................................................................................................6 6.0 Models of predicting future Spot market Rates.............................................................6 7.0 Conclusion.....................................................................................................................10 References…………………………………………………………………………….11 Introduction According to Moffett, Stonehill, and Eiteman, (2003) a market is a place where buyers and sellers come together to facilitate the exchange of goods and services. The characteristics of a market is that it deals with the transfer of different types of goods and services, these goods and services are not necessarily owned by the market, and lastly it is not definite for a market to be physically located. A financial market on the other hand is a marketing environment which initiates the buying and selling of different kinds of financial instruments in relation to established rules and regulations. Examples of financial instruments include currencies, equities and debt securities. Other derivatives of the base entities traded in a financial market include swaps and options, futures, and related financial innovations. Financial markets facilitate the transfer of commodities from the lenders to borrowers so as to meet their personal interests. However, Buckley (2009) emphasizes that financial markets are classified into two that is, money markets and capital markets. The two are distinguished from each other considering the time the assets traded in such markets take to mature. Foreign Exchange Market is the largest international market which trades in currencies. The report focuses on forward market and spot market and how the two co-exist. Forward market and spot market are classification of foreign market based on future delivery and immediate delivery respectively. Therefore the report seeks to establish the extent to which Forward market predicts the existence of Spot market. The Forward Market In the Forward market, an agreement is made between the buyer and seller to buy or sell the desired asset at a future time but a price is agreed upon today. The transaction in Forward market demands that delivery is made at a future date value of a given amount of currency. The exchange rate to be used at the payment date is set during the agreement while delivery and payment are made upon maturity of the contract (Buckley, 2004). Park and Chen (2006) note that forward Exchange rates in the United States are quoted for value 1, 2, 3, 6, and 12 months. However, actual contracts when desired can be planned to take other lengths. It is important to note that forward transactions constitute about 9% of the total foreign exchange transactions. Political, economic and technical factors at times may lead to upheaval in the exchange market which eventually results to volatile exchange rates that affect international trade. Forward exchange contract effectively protects both parties from unforeseen exchange rate fluctuations which are likely to occur between the date of the contract and due date for payment. Calculation of the real value of the export and import order can be done on the day of processing, and this makes budgeting and costing to be accurate (Moffett, Stonehill, and Eiteman, 2003).This therefore implies that both the buyers and the sellers can utilize the forward exchange contracts which provide various financial and commercial transactions. Types of Forward Exchange Contracts There are three types of foreign exchange contracts that exist within the international market. What differentiates them is the period of the contracts as explained below (Buckley, 2009). Fixed Contract In this type of contract Buckley (2009) asserts that foreign currency is delivered on the date of maturity at a specified exchange rate as stated in the contract. The maturity date in this contract is fixed and it expires on that particular date specified in the contract. A Fixed contract occurs when the buyers know very well the actual date of their engagements and therefore their focus is to that date. Under such arrangement, the seller will not be able to deliver until the maturity date contracted expires. However, some options may be provided in case the seller opts to deliver before the date stipulated in the contact matures. Partially optional contract The terms of contract in a partially optional contract are fixed during the initial stages of the contract. On a later stage an option start date set in followed by fully optional until the maturity date is arrived at. The foreign currency is delivered at any time provided it falls between the optional period, and in consideration of the exchange rate specifications in the contract (Cifarelli, 2007). This type of contract combines both fully optional and fixed contracts. It is necessary for customers to use this contract if they are sure they will not need it when option start date sets in. Fully optional contract In this contract, foreign currency is delivered at any time as long as the contract still exists. However, the exchange rate specified in the contract remains the same. Such contracts according to Theobald (2006) have an on maturity date and before maturity date and could be fully or partially utilized at any given time between when the contact was established and its maturity date. The contract is used by customers who do not understand the actual date of their commitment or if they use one contract to facilitate various business transactions. Forward market exchange rates (pricing) The rates of Forward exchange contracts are determined basing on interest differentials that exist between the participating countries, and they don’t necessarily predict the future exchange rates. The interest rate difference that exists between the currencies of the two countries is reflected in the difference between spot rate and forward rate (Batchelor, Alizadeh, and Visvikis, 2007). In the situation where the foreign interest rate is more than the interest rate of the home country, then the foreign currency is seen to have a discount. In this situation, the forward rate will be lower compared to spot rate as Park and Chen (2006) observe and thus the forward contract benefits the importer unlike the exporter. Consequently, when the interest rate for the foreign country is lower than that of home country, the currency for the foreign country is said to have a premium. The forward rate in this particular circumstance will be higher compared to the spot rate. Under this condition, according to Benninga, Eldor, and Zilcha (2006) a forward contract is beneficial to the exporter, but costly to the importer. Forward exchange rates and spot exchange rates rarely appear the same. The most common scenario is that forward exchange rate is either lower or higher than the spot exchange rate. The Spot Market According to Buckley (2004), spot transaction involves the exchange of different currencies, which is done immediately in accordance with the prevailing conditions of foreign exchange market, at an agreed rate. The delivery period in the cash or spot market is normally within two days of business. There are two types of spot rates used in currency exchange that is bid rate and offer rate. A currency is purchased in exchange with another currency at bid rate, while a currency is sold at an offer rate. Foreign exchange delivery in this transaction is almost immediate, and the settlement date is called value date. The mostly preferred transactions in the foreign exchange are spot transactions comprising 43% of the total transactions. Models of predicting future spot rates The forward market unbiased hypotheses provides that the prevailing forward rate on day zero will fully reflect the available information. The hypothesis assumes that the available forward market rates on day zero are unbiased predictors of the future spot market rates. The term unbiased as used in the hypotheses shows that the difference which exists between the actual forward market rate and spot market rate is on average zero (Delcoure et al (2003). It is to be considered that the forward market hypothesis is based on the fact that market is efficient. Considering that the prevailing market is efficient, this therefore means that the market price is a reflection of all information available. Thus, in case the market prices a forward contract reflect a certain value, the forward price established shall reflect the expectations of all market speculators pertaining the prevailing spot market rate in the future. It is in this regard that forward rate should be unbiased predictor of spot rate, in order to for the speculators not to benefit from the bias by taking different positions in both forward market and spot market (Cifarelli, 2007). For instance, if the forward rate for the US dollar consistently under-predicted the spot rate in the future, then it means that speculators were going to buy the US dollars and at the same time compromising on the forward position. In the event the forward contract matures, the forward position could realize profits since the spot rate is likely to fall above the rate predicted by forward market. The argument behind this is that the existing bias is not consistent with efficient market concept. The influence of information in determining exchange rate has been emphasized, and different hypothesis have been used in predicting future spot rates (Batchelor, Alizadeh, and Visvikis, 2007). Another famous hypothesis that is used to explain predictability of a spot market is the expectations theory related to a forward rate model. Under this model it is argued that forward exchange markets rate reflects the available information related to exchange rate expectations, and thus the forward rate is normally considered to be unbiased predictor of spot rate (Delcoure et al 2003).Under the expectation theory, economic agents are in the position to process information at a high rate. Considering economic agents' activities and changes in the market positions, the forward rates are believed to reflect information which is relevant in determining the future spot exchange rates. Random walk model is another hypothesis used to explain forward market and spot market. The model lays more emphasis on the random behavior of exchange rate (Bams, Walkowiak, and Wolff, 2004). This model disagrees with the notion that forward market is unbiased predictor of spot market. According to the hypothesis, since spot rates encompasses all the necessary information used to establish future exchange rates, present spot rate are the perfect predictors of spot rates and not the forward rates. In fact it has been found out that the current spot rates in any foreign exchange market are the best predictors of future exchange rates compared to forward rates. However, previous tests indicate that the supporting evidence to this hypothesis is very weak indeed. A premium risk that is not constant was found to exist in majority of foreign exchange markets (Kavussanos, Visvikis, and Menachof, 2004). This therefore implies that forward rate cannot be solely used to directly measure future spot rate. In order to accurately predict the exchange rate, it should be done based on approximated coefficients considering the exchange rate specifications. A lot researches have been conducted to examine market efficiency hypothesis in relation to foreign exchange markets. According to Benninga, Eldor, and Zilcha (2006), the assumption in the unbiased forward market rate hypothesis is that costs of transaction are minimal, all information is absorbed in both forward and spot market faster, and investors are neutral risk takers. Such a situation leads to occurrence of efficient arbitrage activities up to a level where forward market rate equals to the future spot market rate. In a situation where the current market spot rate has information on present exchange rate movements while the forward market has information regarding the future, it is argued that the resulting average would give an effective estimate of future spot market rate. Initially, empirical research produced varied results to the efficient market hypothesis. The early researchers had strong supporting evidence to the hypothesis because of availability of information (Buckley, 2009). Also, they used the early floating rate and it was hard to make various observations in order to achieve statistical importance. Nevertheless, it was not possible to persistently out do foreign exchange markets since all profits or losses whether they took short or long positions occurred randomly, and this justified the hypothesis that forward market rate is unbiased predictor of the future spot market rate. However, as foreign exchange markets continue to grow many researchers have developed interest in the analyzing different trends. The current studies are more comprehensive compared to early studies. According to Park and Chen (2006), current studies confirm that better predictors of future spot market rates do exist and that they have the capacity to outperform the market. The number of observations has tremendously increased, therefore use of forward market rates to predict expected spot market rate depends on asset prices, latent variables and prevailing risk factors. There is an agreement amongst different researchers in rejecting the market efficiency hypothesis and no premium risk. At any given time when the predicted market forecast error gives a figure that is not a zero, it is possible that market inefficiency, risk premium or even both may exist (Bams, Walkowiak, and Wolff, 2004). However, ascertaining the availability of risk premium has not been achieved. Even though the majority of research on foreign exchange markets has concentrated on joint hypotheses of no premium risk and market efficiency, some research efforts has been directed towards unexploited profit opportunities as a measure of market efficiency. Speculative efficiency was examined from autocorrelation point of view, and the findings indicated that autocorrelation existed (Moffett, Stonehill, and Eiteman, (2003).What this implies is that past information could be used to facilitate predictions of forward market. Conclusion There is an intensive research on forward market unbiased predictability of spot market in developed countries. However, this is not the case in the developing countries due to lack of adequate information. The study indicates that both current forward rates and spot rates are important in the prediction of future spot rate. It is also evident that coefficient estimations are important to be included in new observations during predictions, and that use of constant coefficient assumption leads to biased predictions by the forward market rates. The study also shows that when estimated predictions coefficients for forward market rates and those of spot market rates are not zero, the unbiased predictor hypothesis for the forward market does not apply. References Bams, D. Walkowiak, K. & Wolff, C. C. (2004) ‘More evidence on the dollar risk premium in the foreign exchange market’. Journal of International Money and Finance. 23(2) pp 271-282. Batchelor, R. Alizadeh, A. & Visvikis, I. (2007) ‘Forecasting spot and forward prices in the international freight market’. International journal of forecasting, 23(1) pp 101-114. Benninga, S. Eldor, R. & Zilcha, I. (2006) ‘The optimal hedge ratio in unbiased futures markets’. Journal of futures markets. 4(2) pp. 155-159. Buckley, A. (2004) ‘Multinational finance’. 5th edition, Prentice Hall, London. Buckley, P. J. (2009) ‘Business history and international business’. Business History, 51(3) pp 307-333. Cifarelli, G. (2007) ‘Exchange rate market efficiency tests and cointegration analyses. Economia Internazionale/International Economics, 45(2) pp 197-208. Delcoure, N. Barkoulas, J. Baum, C. F. & Chakraborty, A. (2003) ‘The forward rate unbiasedness hypothesis reexamined: evidence from a new test’. Global Finance Journal, 14(1) pp 83-93. Kavussanos, M. G. Visvikis, I. D. & Menachof, D. (2004) ‘The unbiasedness hypothesis in the freight forward market: Evidence from cointegration tests’. Review of Derivatives Research, 7(3) pp 241-266. Moffett, M. H. Stonehill, A. I. & Eiteman, D. K. (2003) ‘Fundamentals of multinational finance’. Addison-Wesley. Park, H. Y. & Chen, A. H. (2006) ‘Differences between futures and forward prices: A further investigation of the marking‐to‐market effects’. Journal of Futures Markets, 5(1) pp 77-88. Theobald, M. (2006) ‘Testing the relationship between forward and spot rates in Foreign Exchange markets’. Journal of Business Finance & Accounting, 18(1) pp 1-12. Read More